Jason Stipp: I'm Jason Stipp for Morningstar. Morningstar named its 2011 CEO of the Year Award winner on Wednesday: Jim Sinegal, CEO of Costco took those honors.

Here with me to talk about the selection process is Morningstar's Paul Larson, editor of Morningstar StockInvestor and an equity strategist, and R.J. Hottovy, he is working on our consumer team as an analyst.

Thanks for joining me, guys.

Paul Larson: Thanks.

Stipp: Paul, if you could start out and tell us a little bit about some of that broad pillars that go into the CEO of the Year decision. What factors must a CEO meet in order to even be considered for this award?

Larson: Well, one of the things that we're looking for is someone that has had very good stewardship of the entity that they've run. This means having a reasonable compensation, also having incentives [so] the management and shareholders are aligned. Another thing that we're looking for is someone that's added value--both intrinsic value for the company as well as widening the moat, so to speak--and I think Jim Sinegal certainly applies here.

Stipp: So, how do you measure that value-added? What metrics do you look at to see if a CEO is really adding value for a company over time?

R.J. Hottovy: In the retail industry, we're really looking at a few metrics, such as, in this case, really market share. And frankly in the last 20 years, outside of Amazon, we can't find any other situation where we found such a disruptive retailer. Under ... Jim Sinegal's stewardship, Costco has really redefined the retail business, and kind of turned it on its head. Before he came around, the warehouse club model really didn't exist, and now here they are, the third-largest retailer in the U.S., with approximately $65 billion in revenue each year.

Stipp: I want to talk about some of the specific challenges in retail in a moment, but before we get there--Paul, just broadly, as you're looking at 2011, what kind of a year was this for the managers of companies? How tough was it? Obviously, it wasn't a 2008, but there were some bumps along the way last year.

Larson: We did have some headwinds. The sovereign debt situation in Europe as well as here in the United States, frankly. We had the Japanese tsunami, negative headlines. So we had a scared consumer, but this was actually a little bit of a cyclical tailwind for Costco, because consumers are trying to stretch their dollars, and Costco is certainly one way that they can do so by going there and benefiting from the low prices that Costco gives them.

Stipp: Certainly, we've seen Costco benefiting in an environment like that, but they've also had good long-term performance. It's not just in bad years that Costco has done well.

Hottovy: It's had a pretty remarkable track record, and a pretty stable one at that. In the past 27 years, since the company was founded, they've had an extraordinary track record of consistency, mid- to high-single-digit comparable store sales, market share gains from not only specialty retailers, but other mass merchants as well.

It's never going to be a high-margin business. It's just pretty much been a 2% to 3% operating margin business since then, but they overcome that with extremely fast inventory turnover, some of the fastest turnover rates that we have seen, and that also leads to very productive stores as well. Frankly, this company has been the model of consistency in the retail sector for several years.

Stipp: I know in the article that you wrote announcing the winner, you talked about some of the specific challenges in retailing. You have consumer switching costs that are very low. You have commodity costs, which have been an issue for a lot of packaged-food providers, and sometimes those costs get passed along. How was it that Sinegal was able to manage through some of the difficult environment that we saw for all retailers in 2011?

Larson: Well, you point out that this is a difficult industry, and that is absolutely correct. And I think what's interesting about Costco is that the management has managed to overcome all those difficulties to create all those value. This is not a company or an industry where you can have Homer Simpson running the business and basically be hands-off. You have to be very hands-on in this business because it is very difficult.

Stipp: Very few economic moats in retailing, in fact, right?

Larson: There are relatively few, yes.

Stipp: One of the things I think is interesting about Costco is that the model of the warehouse club isn't unique. We have Sam's Club. We have BJ's Wholesale Club. What is it about the way that Costco is run that has made it stand apart from its competitors in this niche space of the warehouse club?

Hottovy: With Costco, when you're only carrying about 4,000 SKUs on the floor at any given time, which rotate based on consumer demand, obviously that puts a lot of pressure on what products actually go into the store. And frankly Sinegal and his merchandising team have had an excellent track record of picking the most sought-after products that that people really want. And by only purchasing about 4,000 or having 4,000 SKUs on the floor at any given time--compared to a mass merchant like Wal-Mart, which carries 60,000 SKUs at any given time--that adds up to quite a bit of bargaining power, which is what can be passed on to the consumer at that time. ...

The other thing is not much advertising, it's all relied on word-of-mouth, just relying on the brand name itself, Costco, knowing that you are going to get a low price. All that can be passed on to consumers, so ultimately that's really where the outperformance lies--being better merchants and just blocking and tackling, really, when it comes down to it.

Stipp: So, Paul, operational excellence, obviously, they've got that under control. What about the stewardship side? You mentioned at the onset of this interview that stewardship was an important consideration. Why is Sinegal a good steward of capital for Costco?

Larson: Well, he has allocated capital wisely over the years. There have been a couple of mergers early on in the company's history, but since that point in time, they really haven't spent a lot of money on areas that haven't panned out.

Also, the management compensation is very reasonable, under $400,000 in base salary for Sinegal and maybe just a couple of million in equity awards, which, for running a company of Costco's size is a very reasonable compensation. And he is getting a vast majority of his compensation through those equity awards, which does align the shareholder interests with the management interest.

Stipp: Certainly always good to see skin in the game.

Hottovy: Absolutely. His compensation levels are a lot lower than some of the small-cap retailers we cover out there, so to see this kind of compensation structure definitely is a breath of fresh air for investors.

Stipp: R.J., something else that you talk about is the way the employees are treated and the corporate culture on that front. How has that given Costco a leg up as a retailer?

Hottovy: I think just by fostering a culture of employee loyalty, it gives consumers at Costco a very consistent experience, and [boosts] morale among employees, which is often overlooked in the retail space. It makes the experience better, and I think that's another point to how they have been able to outperform their closest peers in executing just by keeping employees happy, keeping health benefits there, paying an above-average wage, and not resorting the layoffs or cutting health benefits in tough times.

By really reinforcing that, it has set up a position where Sinegal has got a lot of lifetime followers in the company. And it's a situation too where the company only promotes from within. Most of the upward positions that they hire have been people who have been around the company for quite some time, and I think that just fosters a great environment and an environment these employees want to work for for several years.

Stipp: So, Costco has found that taking on some of those higher costs to keep employees happy, they can make up that money by having a better-run business over time. Certainly it's going to be more expensive to keep all the health-care benefits and to make sure that turnover is lower. It's a certain immediate cost, right?

Hottovy: Absolutely. It may weigh on the bottom line a little bit, but I think ultimately the reward is in not only keeping members happy, but low employee turnover and just that consistency.

Larson: And the higher productivity and the higher sales per square foot is certainly one area where I think you're going to see that.

Hottovy: Absolutely. Costco right now generates close to $150 million per location. That translates to about $1,000 per square foot. That's typically the range you see for a high-end luxury retailer or a jeweler even. So, the productivity levels that Costco is able to squeeze out of a 140,000-square-foot location has been nothing short of impressive.

Stipp: So, obviously, Sinegal's a very accomplished manager. ... Can you talk a bit, though, about the stock price? If you're an investor and you're looking at Costco, you like the business story, does the stock price look good?

Hottovy: Right now we think the stock is actually slightly overvalued. Our fair value estimate is $80 per share. The stock is currently trading at about $84. If there were any undue points of weakness, we'd be looking to build a position at that point. That said, we could see a situation where we see inflows into the more defensive names in the U.S., given the situation in Europe. So, in a capital preservation strategy, I think Costco may have a place in your portfolio. The company also, as Paul has alluded to during this interview, did a great job returning cash to shareholders through dividends and share buybacks, and so for more income- and value-focused investors, Costco may be another name to take a closer look at.

Stipp: And last question for either one of you: Sinegal is actually stepping down from CEO duties at the beginning of this year, I believe. Does that have any effect on how you should think about the company? Is the culture in place where Sinegal can step away from those CEO duties and we still see the same kind of operational excellence?

Hottovy: I think Jim's done a great job fostering the perfect kind of work environment where the day-to-day values of the company are reinforced. Craig Jelinek, who is the chief operating officer, will be taking the reins from Jim. Jim will remain on for this next year as a consultant and will remain on the board after that, but both these guys have had a long history. They came up through the system, through FedMart and Price Club through the early part of the '80s and '90s, and I think that gives them nice consistent experience, and we'll see a seamless transition under the new leadership.

Stipp: All right guys, thanks for giving me all the details on the selection of Jim Sinegal, CEO of Costco, for Morningstar's 2011 CEO of the Year Award.